How do private equity funds measure performance?

Analysing alternative investment performance

Typically, alternative investment is an investment in an asset classes other than shares, bonds and cash.

In private equity ownership, the equity component refers to an investor’s stake in a private company and its subsequent value after all debt has been settled.

In the world of private equity, limited partners (LPs) are investors who contribute capital to a PE fund (called a Limited Partnership) to invest with the aim of generating returns within a specific time period. General partners (GPs) are organisations who identify, purchase and manage the investments on behalf of the LPs.

When it comes to analysing the performance of alternative investments such as private equity, context is crucial. Private equity comprises a wide variety of company stages and sectors, so evaluating the performance of each requires a different set of metrics and knowledge.

For this reason, many GPs in PE firms specialise in two or three industries to fully understand their component parts and track new developments.

Private equity performance measures

Performance in private equity investing can be measured using the internal rate of return (IRR), the multiple of money (MoM), and the public market equivalent (PME). But, while IRR, MoM and PME are widely used metrics, they do have some limitations as methodologies in evaluating PE funds’ performance.

- Internal Rate of Return (IRR)

The IRR is defined as the compounded rate of return on an investment or series of investments. It reflects the performance of a PE fund by taking into account the size and timing of its cash flows (capital calls and distributions) and its net asset value at the time of the calculation. When applied as a discount rate, the IRR makes the net present value (NPV) of future cash flows equal to zero.

However, this methodology can be problematic as it implicitly assumes that the cash proceeds have been reinvested at the IRR over the entire investment period. For example, this would mean that if a PE fund reports a 50% IRR and has returned cash early in its life, the cash was put to work again at a 50% annual return. In reality, investors are unlikely to find such an investment opportunity every time cash is distributed.

Modified IRR (MIRR) helps to overcome the reinvestment assumption problem of the standard IRR model by assuming that positive cash flows to LPs are reinvested at a more realistic expected return, such as the average PE asset class returns or public market benchmark levels.

Also, MIRR accounts for the cost of uncalled capital, unlike the standard IRR model. By basing the IRR on more realistic assumptions for both reinvestment and cost of capital, MIRR can provide a more accurate measure of PE performance.

- Multiple of Money (MoM)

The MoM, also known as the cash-on-cash return, multiple of invested capital (MOIC) or total value to paid-in capital (TVPI), compares the amount of equity the investor takes out on the date of exit from the fund relative to the initial equity contribution.

The formula for calculating the MoM is a straightforward ratio that divides the total cash outflows by the total cash inflows from the perspective of the investor. For example, if the total cash outflows are $100m from a $10m initial investment, the MoM would be a 10.0x multiple.

However, the MoM metric should not be used by itself as it fails to consider the time value of money. For instance, a 2.0x multiple could be sufficient for certain funds if achieved this return within three years. But that might no longer be the case if receiving those proceeds took 10 years to eventuate instead.

The calculation of MoM quantifies ‘how much’ the gross return was, as opposed to ‘when’ since time is not factored into the formula. In contrast, the IRR takes into account both the amount received and the timing of when the proceeds were received, but this causes the metric to be potentially skewed by attaching more weight to proceeds received earlier.

In combination, the metrics are useful as the higher the IRR and the MoM, the more profitable a PE investment should be.

- Public Market Equivalent (PME)

In some cases, investment committees may want to compare a PE fund’s performance with that of more traditional asset classes. This can prove difficult as unlike listed or traded instruments, much of a PE fund’s performance reporting relies on interim valuations of unlisted and illiquid investments, making precise mark-to-market valuations impossible.

To provide a comparison, a frequently cited method is the public market equivalent (PME) approach, an index-return measure that takes the irregular timing of cash flows in PE into account. PME compares an investment in a PE fund to an equivalent investment in a public market benchmark, such as the S&P 500.

The PME metric is also useful to include in PE performance analysis because it considers the timeframe and state of the economy at the time of valuation.

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